RONALD COASE INSTITUTE
Working Paper 6
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Can Aid Reform Institutions? Mary Shirley, Ronald Coase Institute Abstract Can aid reform institutions? The realities of foreign aid and the nature of aid-giving organizations are at odds with what we know about institutional change: that it is often gradual, path dependent, context specific, and contrary to notions of best practice in Western countries. Empirical analyses find no positive correlation between aid and better institutions or between aid and growth in GDP per capita. If aid cannot reform institutions, can aid avoid damaging institutions? Efforts to avoid the ill effects of damaging institutions by insulating aid projects or by relying on NGO's or beneficiary participation, have met with mixed success. Efforts to aid only those poorer countries that are already improving their institutions confront serious measurement problems. This paper calls for more experiments, better local information, more case studies of the institutional prerequisites for the implementation of high priority policies, and greater local capacity to design sustainable institutional reforms. Keywords Foreign aid, institutional change, poverty reduction JEL classification O1, B52 Date April 2005 Copyright © 2005 The Ronald Coase Institute Contact
[email protected] Suggested citation Mary Shirley. “Can Aid Reform Institutions?” April 2005. Ronald Coase Institute Working Papers, Number 6. http://www.coase.org/workingpapers/wp-6.pdf JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ
Draft, April 28, 2005 Comments welcome to
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Can Aid Reform Institutions? 1 Mary M. Shirley, President, The Ronald Coase Institute 1. Introduction Since the end of World War II the foreign aid community has burgeoned. Annually, twenty one multilateral and 36 bilateral organizations are responsible for over $150 billion in foreign aid, while thousands of private, international non-governmental organizations provide another $ 10 billion (Table 1).2 These aid giving organizations are dedicated to the proposition that underdevelopment can be eliminated and poverty eradicated. The World Bank mission statement is emblematic: “Our dream is a world free of poverty.” Yet the dreams, money, and good intentions of aid givers notwithstanding, most people in aid recipient countries still live in appalling poverty. If we define development to mean countries with per capita incomes in the World Bank’s high-income category (above $9,076 in 2002) then most of the world’s population live in underdeveloped countries. This circumstance has changed little in recent decades as we can see in Graph One (World Bank 2002, 2003).
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Preliminary work on this paper was done while visiting Stanford University’s Center for International Development in March 2004. Conversations with researchers at SCID and comments from participants in a SCID seminar have greatly clarified by ideas on this subject, and I owe a debt of gratitude to Roger Noll, as well as to Lee Benham, Avner Greif, Nick Hope, Douglass North, and Barry Weingast for their insights. My thanks also to SCID staff for their help and friendship and to participants in seminars at the Mercatus Center at George Mason University and the International Food Policy Research Institute. Errors and fuzzy thinking are my own fault of course. 2
There were 17,428 international NGO’s in 2000, at least to judge from the number of headquarters (London School of Economics 2003).
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Graph One: World Population Living in Developed (DC) or Less Developed (LDC) Countries, Percentages 90 80 70 60 50 40
LDC
30 20 10 0
DC
1981
2002
Source: World Bank, World Development Reports, various. Developed is defined as countries ineligible to borrow from IBRD (the World Bank’s window for loans on harder terms), above US$9,076 in 2002.
Although there has been a reduction in absolute poverty, thanks largely to growth in China, few countries have graduated from underdevelopment. Progress has been especially slow for those at the bottom. The poorest three fifths of countries have had zero growth in income per capita since 1981 (Easterly 2002b). Disparity between rich and poor countries has increased. The disparity between rich and poor populations has decreased, thanks again to growth in China and to a lesser extent, India, but for reasons I discuss later, it is highly doubtful that China’s success can be attributed to aid.3
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Sala-I-Martin (2002) finds convergence in incomes when inequality is measured in terms of purchasing power and weighted by population because of the large proportion of people living in China who saw their incomes rise over the last decade. The disturbing stagnation of African economies explains why these countries account for over 95% of the world’s poor (Sala-I-Martin 2002, p.39).
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Table 1: Size of the Aid Community in 2003
Type of Aid Agency
Number
International Financial Institutions African Development Bank Asian Development Bank European Development Bank InterAmerican Development Bank International Monetary Fund World Bank (IBRD, IDA, IFC) Other (Caribbean Development Bank, Council of Europe, Int’l Fund for Agric. Dev., Nordic Development Fund) Total IFIs United Nations agencies (UNDP, UNFPA. UNHCR, UNICEF, UNRWA, UNTA, WFP, Other UN) Total UN Other Multinational Aid Agencies European Community Global Environmental Facility Montreal Protocol Fund Arab Funds Total Bilateral Aidb Development aid, OECD members of DACc Of which, Netherlands United States Debt reorganization Of which, debt forgiveness Development aid, non DAC membersd Total Grants by Private Voluntary Organizations
10
Assistance a 2003 $ 1,555 $ 3,826 $ 907 $ 9,002 $ 1,187 $ 19,638 417
$ 36,532 7
$ 3,467 4 $ 8,212 $ 107 $ 66 $ 202 $ 8,587 22
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$ 90,391 5,027 29,750 $ 8,554 8,338 $ 3,129e $102,075 $ 10,162
TOTAL ASSISTANCE $160,824 Concessional and non-concessional gross disbursements to developing countries (as defined by the OECD) with promotion of economic development as the goal at current prices converted to US dollars at current exchange rates. b Includes grant and grant like contributions (including technical co-operation, development food aid, emergency and distress relief, contributions to NGOs, and administrative costs) and new development lending. c Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Luxembourg, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, UK, US. d Czech Republic, Estonia, Hungary, Iceland, Israel, Korea, Kuwait, Latvia, Lithuania, Poland, Saudi Arabia, Slovak Republic, Turkey, and United Arab Emirates. China also provides aid but does not disclose the amount. e Net. Sources: Calculated from OECD (2005, Tables 13, 17, and 33). a
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What causes some countries to be underdeveloped? In the 60 years since the Second World War ended the aid community embraced and discarded a number of different explanations, as I describe in Section 2.
Currently (2004) institutional
explanations are in vogue, as the following quotes suggest: •
“Addressing the challenge of building effective institutions is critical to the Bank’s mission of fighting poverty.” (World Bank 2002, p.iii)
•
Sustainable and equitable development requires a democratic, modern and efficient state that promotes economic growth, establishes a regulatory framework conducive to the efficient functioning of markets, that guarantees a stable macroeconomic environment, that is capable of adopting social and economic policies appropriate for poverty reduction and environmental preservation, and that implements such policies in an efficient, transparent and accountable manner. In the development debate a consensus has formed that the quality of public institutions is an essential, and perhaps the most important ingredient for sustainable economic growth.” (InterAmerican Development Bank 2003, p.9).
•
“Development interventions are more likely to succeed if they promote improvements in wider institutional competencies as well as in technical competencies” (Department for International Development 2003, p.5). Institutional factors correlate strongly with growth, as I discuss in section 3, but
this raises as many questions than it answers. How do institutions affect development, and how do you get well functioning institutions? The literature has only partly addressed these questions and there are many gaps in our understanding but some findings emerge from the new institutional economics (NIE) These findings challenge the proposition that aid can reform institutions, especially when we consider the nature of aid and of aid organizations (section 4). The empirical evidence also suggests that aid has had little measurable influence on institutions in recipient countries, although some challenge these conclusions. If aid cannot reform institutions can it avoid those institutions that could undermine aid efforts? In section 5, I consider efforts to insulate
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aid projects from damaging institutional environments or to bypass damaging governments and conclude that they have mixed success, success that is vulnerable to institutional disequilibria over time. Greater selectivity is sensible under these circumstances, but our limited understanding of what constitutes meaningful institutional change in specific cases makes it hard for aid givers to know whether they are accurately measuring a country’s institutional capacity to use aid effectively (section 5). I conclude in section 6 with some suggestions for alternative approaches: more experiments and greater use of markets; improving our knowledge of the institutional prerequisites and political circumstances that allow countries to implement reforms; and building competency inside and outside government. 2. What Causes Underdevelopment? In The Elusive Quest for Growth, Bill Easterly provides an insightful and entertaining account of the various explanations for underdevelopment that economists have proposed and the aid community has embraced over the years.4 Most prominent among the justifications for foreign aid are: (i) under-investment or too little technological innovation; (ii) lack of education; and (iii) market-unfriendly
4
There are other explanations based on traits that defy or resist reform, such as geography (see, for example Gallup, et al. April 1998) or the so-called curse of natural resources (see papers cited in Wright and Czelusta 2003). These explanations leave little scope or rationale for foreign aid. The geographical explanation argues that countries are underdeveloped because they are cursed with dangerous diseases; high transport costs because they are landlocked, mountainous, or lack good ports; low agricultural productivity because their terrain is arid or prone to flooding or drought; or high population density on areas suitable for agriculture but not easily accessible for trade. Geographical explanations ignore the prior wealth of some of today’s poor countries, such as Egypt or Persia, and the inhospitable conditions that once prevailed in some of today’s wealthy countries, such as malaria in the Southern US or flooding and high population density in the Netherlands. The resource curse explanation argues that abundant and valuable natural resources like oil corrupt a country’s governance and promote under-investment in other productive sectors. But this reasoning ignores successful resource rich countries such as the US, Australia, or Norway. The US, for example, dominated world petroleum production from the late 1800’s until 1960 (Wright and Czelusta 2003, p.13).
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macroeconomic policies.5 Easterly shows how each of these justifications was adopted and discarded when they failed to deliver the promised growth. It was reasonable to assume that investment, innovation, education, and sound macroeconomic policies could stimulate growth; they do promote growth in developed countries. But the assumption that these measures would function in every economy in the same way proved to be wrong. Reforms in developed countries set off a virtuous circle of changes that reinforce one another. But underdeveloped countries are trapped in a low-level equilibrium. Only if the root causes of that equilibrium are removed do reforms promote growth. Under-investment, lack of innovation, too little education, and bad policies may be proximate causes of underdevelopment, but they are not ultimate causes, and correcting them is not enough to move countries out of a low-level equilibrium trap. Consider the case of education. Initial levels of secondary education in 1900 are correlated with current levels of GDP per capita, which has led some analysts to argue that human capital is more important than institutions in growth (Glaeser, et al. 2004). But increases in years of schooling of the labor force are not correlated with growth in GDP per worker in developing countries, except perhaps negatively (see Easterly 2002b, chapter 4, Prichett 1996). As Easterly points out, the quality of education is higher in economies that provide incentives to invest in the future: “Students will apply themselves to their studies, parents will monitor the quality of education, and teachers will face pressure to teach” (Easterly 2002b, p.82). If incentives to invest in the future are low, educational quality will be poor and there will be under-investment in learning. There are many examples of 5
This discussion draws heavily on Easterly (2002b).
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poor educational quality in developing countries: on any given day a third of all teachers in Uttar Pradesh, India are absent; 70 percent of students who completed grade 5 in Bangladesh are not minimally competent in writing; the 1994 Tanzania Primary School Leavers Examination found that four-fifths of students scored less than 13 percent correct in language or mathematics after seven years of schooling (World Bank 2004, p.112). Aid projects that fund investments in building schools, buying textbooks, training teachers, or reorganizing the ministry of education will not have much effect on learning or growth if parents and students expect low returns from schooling and teachers or administrators do not expect to be held accountable by the community, the polity, or the bureaucracy. 3. The Role of Institutions in Development Ultimately, as the education example shows, an economy’s future rests on choices made by economic, political, and social actors, choices that are motivated by institutions. Institutions are the “humanly devised constraints that structure human interaction,” and include formal constraints such as constitutions and laws and informal constraints such as norms, conventions and self-imposed codes of conduct (North 1990, p.3).6 As North explains, institutions are the product of intentional human efforts to provide structure in an uncertain world, and are congruent with a society’s dominant set of beliefs about how that world operates (North 2004). Successful market economies are characterized by institutions that (i) foster exchange by lowering transaction costs and encouraging trust, and (ii) stimulate state actors to protect property and individual rights rather than expropriate and exploit them (Shirley 2005 forthcoming). 6
Organizations differ from institutions; “they are groups of individuals bound together by some common purpose to achieve certain objectives,” and include legislatures, firms, trade unions, churches, clubs, schools, etc. (Ibid.)
7
Cross-country regressions persistently demonstrate large and statistically significant correlations between institutional variables and growth in income per person (for a survey see Aron 2000). In horse races between variables, an index of institutional quality “trumps” geography or trade as an explanation for growth (Rodrik, et al. 2002). This econometric evidence shows that institutions are important to growth, but it does so at a high level of aggregation that leaves unanswered the questions of which institutions matter and how to achieve them. A frustratingly large number of institutional variables are statistically significant. As Table 2 shows, growth in GDP per capita is significantly and positively correlation with protection of property rights and enforcement (seven studies); civil liberties (ten studies); political rights and democracy (ten studies); and institutions supporting cooperation, such as trust, religion, and the extent of social clubs and associations (four studies); and negatively with political instability (15 studies) (Aron 2000). Table 2: Studies Showing Significant and Positive Correlations between Institutional Variables and Growth in Per Capita GDP Significant Variables
Number of Studies
Protection of property rights and enforcement of contracts
7
Civil liberties
10
Political rights and democracy
10
Political instability
15
Institutions supporting cooperation (trust, religion, social clubs, etc.) Source: Adapted from Aaron 2002.
4
Many of these institutional variables are aggregates of a number of specific institutions. Democracy, for example, depends on franchise rules, laws affecting voter access to information (such as those governing the media), constitutional divisions of power
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between legislative, executive and judicial branches, norms that govern how people view corruption, law, or cooperation, etc. Sorting out the role of specific institutions from this evidence is problematic. Some of the “institutional” variables in Table 2 are not institutions, but outcomes of institutions. Secure property rights is not an institutions but the result of laws governing contracting, copyright, and trespass, and of rules and norms about how these laws are enforced and obeyed. Proxies further confuse. Trade protection, black market premiums, and socio-economic conditions such as ethnic linguistic fragmentation, have all been defined as proxies for institutions. It is not clear why these variables are proxies for institutions rather than direct determinants of growth, nor can we be sure which specific institutions they proxy (Shirley 2005 forthcoming). Even though institutional variables consistently explain a sizeable portion of economic growth, these studies fail to identify and test the specific casual institutions that lead to secure property rights, rule of law, or other characteristics of developed economies. They also fail to rule out the possibility that beneficial institutions are endogenous, a product of growth rather than its cause. Progress in our understanding must await better measures of specific institutions and further analysis of how institutions change. What Does New Institutional Economics Tell Us About Underdevelopment? Why have some countries evolved institutional frameworks that foster growth and social progress and others have not? In trying to answer this question, new institutional economics has explored a historical number of factors, most notably, colonialism, political competition or warfare, and beliefs or norms, as listed in Table Three. Since I
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describe this literature in detail elsewhere (for a survey see Shirley 2005 forthcoming), I briefly summarize the arguments here. Table 3: Why Do Some Countries Have Underdeveloped Institutions? Explanations Colonial Heritage
Summary Colonies inherited poor institutions from colonial masters. Colonizers adapted institutions to enslave natives & exploit opportunities for plantation agriculture or mining. Boundaries of African states contributed to ethnic conflict & unaccountable governments. Beliefs & Norms Beliefs or norms inhospitable to trust & markets raised cost of building institutions to encourage impersonal trade & investment. Source: (Shirley 2005 forthcoming).
Authors (North 1990, 1994a) (Acemoglu, et al. 2001a, 2001b, Engerman and Sokoloff 2002)
(Greif 1993, 1994, Knack 1997, North 1990, 1994b, 2004)
Colonization. Most underdeveloped countries were once colonies, and many studies argue that weak institutions are a colonial legacy. But since countries such as Canada and Jamaica had the same colonial master but very different levels of economic development, some scholars argue that colonizers must have adapted their institutions to local conditions in ways that affected subsequent economic development. In South America and the Southern United States, for example, where colonialists encountered a large indigenous population that could be enslaved and/or a climate and soil suited to plantation agriculture, they developed institutions that exploited these opportunities, such as slavery. They also delayed introducing institutions that promote greater equality, such as rules that encourage immigration, expand the franchise, and extend access to secure and cheap schooling, banking and land (Engerman and Sokoloff 2002). In the Northern US or Canada, where the indigenous population resisted enslavement and the soil and climate were not suited for plantation agriculture, the opposite occurred. Colonists settled in greater numbers and developed institutions that fostered greater equality of income, skills and power, laying the foundations for industrialization and a consumer 10
market. This explanation works better for the Americas than for Africa, where neither differences in the colonial institutions nor differences in climate or agriculture can explain why African countries have similarly low levels of development.7 Some scholars fault colonialism for failing to build state institutions and for drawing the boundaries of states in Africa in ways that made destructive ethnic conflicts more likely (Bates 2001, Herbst 2000). Beliefs and Norms. Beliefs and norms also explain why some countries fail to prosper. Beliefs may hinder trust, which keeps people from transacting with strangers or relying on impersonal contracts and court enforcement of agreements (Knack 1997). Avner Greif shows how outmoded belief systems and norms of behavior can hinder progress, contrasting the individualistic cultural beliefs of the Christian Genoese and the collectivist cultural beliefs of the Jewish Maghribi traders (Greif 1994).8 The Maghribis’ collectivist beliefs were congruent with their horizontal social structure; Maghribi traders relied on partnerships, community ties, and “formal friendships” among cooperating traders to enforce bargains. Genoa’s individualist beliefs underlay a vertical social structure; its merchants evolved bills of lading, written contracts, laws, and permanent courts to support bargains among traders who might be strangers from outside their social network. Ultimately, the Maghribis’ failure to develop formal contracts, laws, and courts confined their trade to their network, where their collectivist enforcement was effective, while the Genoese grew rich through extensive and expanding trade protected by their 7
Acemoglu et al. argue that dangerous diseases curbed European settlement in Africa, which meant that colonists did not bring their superior institutions to Africa except to those safer colonies where more Europeans settled because the risk of diseases was less: Rhodesia, South Africa, Kenya. This does not explain the recent economic decline in these countries despite their presumably superior institutions and ignores the large European settlements in other places with dangerous diseases, such as the West Indies. 8
He terms cultural beliefs the ideas and thoughts common to a group of individuals that “govern interaction between these people, and between them, their god and other groups” (1994, p.915).
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impersonal institutions. Greif’s analyses could explain why societies that were once wealthy such as China or Egypt become poor as circumstances change while belief systems and institutions lag behind. How Do Institutions Change? This is a crucial question because, as North points out, we know which policies and institutions promote development, yet we don’t know how countries can attain them. The institutional framework, the fundamental set of institutions that determine the environment for economic transactions, usually changes only incrementally. According to North, change is driven by competition, as institutional innovators see an opportunity to earn money, power, prestige and other rewards. Where status quo institutions compete with new rules of the game, the benefits of change are more apparent and dysfunctional institutions are more likely to be scrapped. The Western market economies arose in competitive, decentralized environments, the Netherlands and England, where many different economic experiments could be tried (North 2005, p.138). New ideas, such as the Enlightenment in the Middle Ages, and greater access to education and information can also be forces for change. But powerful individuals and organizations that benefit from the status quo will oppose institutional changes that might undermine their power and authority. These elites will try to control access to subversive knowledge and information and squelch dangerous ideas or innovators. Even without this active opposition, institutional changes are only sustained when society’s underlying belief system changes congruently, so that people incorporate the new institutional framework into their social norms. The acceptance of new rules as new norms of behavior transforms changes in laws into changes in practice. But as Greif’s
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story of the Maghribis illustrates, humans tend to resist changing their beliefs and habits, even when these beliefs and habits are economically costly. Despite gaps in our understanding, new institutional economics does provide guidance about the nature of institutions and institutional change that can help us assess the role of foreign aid. Three conclusions are particularly relevant: 1. While many institutional changes occur at the margin, a society’s fundamental institutional framework tends to be durable, lasting for centuries. Changes in less fundamental institutions are seldom successful if this broader institutional environment remains unchanged. For example, reformers may introduce a better commercial code, but its enforcement depends on laws governing legislative, bureaucratic and electoral choices; rules about the selection, motivation, and independence of judges; societal norms about corruption and commercial dealing; disclosure rules that make it possible to discover wrong-doing; and many other institutions. 2. Institutional frameworks endure because they are congruent with power structures and shared beliefs. Powerful people who believe they benefit from the institutional status quo that produced their power or wealth will actively oppose change.
Even without active oppositions to reform,
humans evolve habits and beliefs that make them resist revolutionary changes.
Without changes in power structures and shared beliefs,
institutional reforms will lead to large disparities between laws on the books and laws in practice.
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3. Changes in institutional frameworks do occur and can be abrupt, revolutionary,
and
idiosyncratic, emerging
from
experimentation,
competition, and adaptation to local conditions. 4. Institutions and Aid Characteristics of Country Institutions vs. Characteristics of Aid By contrasting the characteristics of institutions with the characteristics of aid and aid organizations we can see why aid may be a poor tool for reforming institutions. 1. Institutional frameworks tend to be durable, but sustainable reform depends on changing them. The information, knowledge, and incentives of aid agencies are not focused on changing underlying institutional frameworks. Aid is aimed at changing policies, sector regulations, or organizations, not constitutions, norms of behavior, or electoral systems. This focus is inherent in the nature of aid (see 2 below) and has persisted even as donor rhetoric has changed.9 Even if aid were redirected toward changing institutional frameworks, its tools are poorly suited for longer term efforts. Aid projects tend to be relatively brief, less than three years, and project staff is rotated frequently, typically every three to five years.10 Because of rotation, those supervising the execution of the project are seldom those who designed it and won approval. (As one World Bank colleague put it to me, you should “move before your mistakes catch up with you.”)
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Although aid documents propose institution building, they often broadly define institutions to include rules or organizations that are more tractable to outside influence than more embedded formal rules and informal norms. For example, recent World Bank World Development Reports define institutions to include policies such as interest rates and organizations such as banks (World Bank 2002, 2003). 10 World Bank staff are encouraged to move every three years; SIDA’s average staff time in one assignment is four years (Ostrom, et al. 2002, p.143)
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Even without rotation, aid staff has few incentives to challenge fundamental rules and norms. Evaluating aid staff is difficult: because development is multifaceted and hard to measure, it is impossible to assign responsibility for economic outcomes to the actions of individual staff. Those aspects that are most easily monitored – project approval or disbursement -- are the ones most likely to influence careers (Martens, et al. 2002, p.20). Despite much rhetoric to the contrary, World Bank staff was rewarded for project approval, not for long-term project sustainability, throughout my tenure there; reports on other donors document the same focus on “moving the money.”11 2. Institutional frameworks are supported by norms, beliefs systems, and powerful elites who benefit from the status quo. Aid agencies are not in the business of fomenting revolutions in politics or beliefs, and would soon be required to leave if they were. Donors work with the acceptance of governments in the recipient country and any project they finance requires a supportive or at least a permissive government. Political, religious, social, or other local leaders would oppose aid payments designed to alter constitutions, norms, or beliefs in ways that might undermine their authority and power. This is the case whether the leadership is what the UN Millennium project report calls “larcenous” or is what the report calls “well intentioned” (UN Millennium Project 2005). Leaders that don’t take this position don’t endure very long. Government and interest group leaders could conceivably be won over through persuasion, reassured through additions to their power in other spheres, bought off with side payments, or neutralized thorough publicity campaigns. But most aid
11
See Ostrom (2002). (See also Easterly 2002a, Martens, et al. 2002, .)
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agencies resist playing such a direct role in financing change and fighting its opponents as outside their mandate or dangerous meddling in internal politics.12 Staff members have strong incentives to cooperate with incumbent governments.13 A hostile government disrupts the project pipeline and leads to an inactive period that can adversely affect the staff member’s budget, prestige, power, and prospects for promotion. Even when the aid agency’s counterpart is a non-governmental agency or private enterprise, the government in the recipient country must at least tacitly permit the aid project to go forward. Donors lose leverage once a project is over, but staff rewarded for project approval has little incentive to hold new projects hostage to government’s performance on its earlier commitments in aid projects that were probably designed by a predecessor.14 Aid agencies tend to select as staff highly motivated, skilled, and altruistic individuals with a bias towards optimism and activism, individuals who may be reluctant to classify any government or problem as intractable. 3. Institutional changes can be abrupt, unpredictable, and idiosyncratic. Aid agencies are bureaucracies accountable to donor governments, and as such prefer to support Western best practice that can be more easily defended to their
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The bylaws of the World Bank require it to be apolitical. Some bilateral agencies are required to support democracy in recipient countries, but they too avoid involvement in politics and require de jure evidence of elections rather than de facto proof of representation and accountability. 13 This has an effect on reporting. World Bank reports that criticize an incumbent government are held in limbo or censored by project staff if they could adverse affect the project pipeline or influence an election. For example, a research report critical of the way Peru’s Fujimori government had managed Lima’s water system reform was held up by staff working in the country department because of the way the paper analyzed the government’s political motivations, and attributed the failure to privatize to the president’s desire to win votes. The paper was deemed a “liability” to the World Bank) since it would be seen as attacking the president before an election. The researchers were required to meet with one of Fujimori’s advisors to discuss changes which would make the report acceptable to the government. Even after agreed changes were made the country staff allowed it to be released for publication only after Fujimori was ousted in 2000. 14 This incentive problem can be tempered if a staff member has several clients or if the recalcitrant government is not particularly important to a donor’s portfolio of projects, or heightened if responsibility for project approval is in field offices.
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sponsoring governments than home grown reforms. They also prefer changes that can be instituted rapidly and be easily used as benchmarks for dispersing funds and assessing outcomes. This results in a focus on de juri rather than de facto change. De facto change is often slower, and is usually only measurable after the project is ended, if at all. China’s success in experimenting with institutional changes within a framework of Communist ideology, totalitarian rule, tenuous property rights, and weak rule of law illustrates the challenge to aid. China’s federal system allowed provinces and local governments to compete by experimenting with different economic rules as long as the dominance of the Communist Party went unchallenged (Weingast 1995). Many townships and villages permitted private investors to run government-owned enterprises in exchange for regular payments to the local government that “owned” the firm. These so-called TVEs (township and village enterprises) allowed capitalistic incentives to flourish within an officially socialist system and contributed to China’s surge in growth (Keefer and Shirley 2000). Despite their prominence, aid givers neither sanctioned nor supported TVEs. This is not surprising since aid agencies have no mandate to promote competitive experiments such as TVEs that rely on informal ties to the locality and, frequently, corruption, to secure their property rights. Pro Forma Reforms When aid is provided in settings where an inhospitable institutional framework is left unchanged, the usual result is pro forma reforms. The situation is similar to that described by Buchanan as the Samaritan’s Dilemma (Buchanan 1977). The payoff is highest to the Samaritan if the Samaritan provides aid and the beneficiary responds by exerting high effort. But the payoff is highest to the beneficiary if s/he receives aid
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without increasing effort. The weaker a country’s institutional framework, the greater the risk of Samaritan’s Dilemma. As Ostrom notes, “When the recipient country is governed by officials who are primarily interested in seeking out opportunities for private gain, and few institutions are in place to keep these motivations in check, moral hazard problems can become substantial” (Ostrom, et al. 2002, p.11). Since incentives in aid agencies are directed at project approval rather than sustainability, aid staff is often complicit in accepting pro forma reforms rather than requiring extra effort in exchange for aid. The recent popularity of foreign aid projects directed at institutional reform may make these problems worse, because institutional projects lack tangible outputs, making impact “more diffuse and hard to verify” (Martens, et al. 2002, p.17). An example of how pro forma reforms work in practice is the performance contract, which enjoyed a vogue among aid agencies in the 1980’s. Performance contracts between a government and the managers of its state enterprises were championed by donors as a way to improve performance of state enterprises by setting specific targets and giving managers incentives to achieve them (Shirley and Xu 1998). Shirley and Xu (1998) found that in five of the six cases they studied governments signed performance contracts but failed to negotiate tough targets, demand the information needed to judge performance, pay promised bonuses for good performance, impose promised punishments for bad performance, or provide promised autonomy to lay off workers or close plants. Targets were weak and distorted. Although all the firms in the sample achieved their targets, there was no pattern of improvement in their trends in total factor productivity, labor productivity, or return on assets (Shirley and Xu 1998, World Bank 1995). Shirley and Xu’s analysis of over 500 performance contracts in China also
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found no statistically significant positive correlation between contracts and improvements in total factor productivity after controlling for selection bias and unrelated reforms (2001). Performance contracts were widely supported in aid projects. Aid officials liked performance contracts because funds could be disbursed against a tangible action–signing the contract – and results gauged by a tangible outcome – achieving the targets. The signing of the contracts could be used as evidence of reform and as a concrete target for approval or disbursement. Aid staffers had few incentives to scrutinize the effects of contracts on subsequent enterprise performance, since they were rewarded for project approval and disbursements, not subsequent performance.
High rates of staff rotation
and constraints on staff time also made scrutiny of such apparently successful projects unlikely. Performance contracts also allowed projects to go ahead where privatization was politically unacceptable and past poor performance of state enterprises made further assistance impossible without some evidence of reform. Recipient governments liked performance contacts because they could sign contracts and achieve their targets without politically costly actions. State enterprise managers could be forced to sign the contract and contract targets could be designed to be achieved without layoffs, plant closures, firing of incompetent mangers, or other changes that might have nasty political repercussions. A Poor Track Record Under the circumstances, it should come as no surprise that aid has had little measurable success in improving institutions. Burnside and Dollar cite a number of studies suggesting aid has no beneficial effect on policies and institutions, concluding
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that “…there is broad agreement that giving a large amount of financial aid to a country with poor economic institutions and policies is not likely to stimulate reform, and may in fact retard it” (Burnside and Dollar 2004, p.4). Several authors go farther, arguing that aid has a negative effect on institutions, fostering rent seeking and corruption and tying up valuable resources in unproductive administration, effects which counteract any good outcomes from aid projects (Bauer 1991, Kanbur 2000, , cited in Harms, 2004). By reducing government’s dependence on its citizens for tax revenue, aid makes the public sector less accountable and responsive to its citizens (Bates 2001, Herbst 2000). The large and cumbersome bureaucracies required to implement aid projects and meet aid reporting requirements have contributed to centralized administration and raised transaction costs (see Easterly 2002a). Higher aid levels have been shown to erode the quality of governance, as measured by indexes of bureaucratic quality, corruption, and the rule of law (Knack 1997). The strong association of aid with a rise in rent seeking in less open economies and in those with large public sectors may account for the ambiguous effects of aid on growth (Economides, et al. 2004). A Challenge to this Conclusion: The UN Millennium Project The report of the UN Millennium Project argues that aid can promote institutional improvements in many poor countries. The UN Millennium Project lays out a strategy to implement the Millennium Development Goals, a set of laudable and ambitious goals developed at a UN meeting in Monterrey on DATE (The goals are shown in table four). The report of the Millennium Project notes that measures of institutions are correlated with income, and concludes that “…good governance helps achieve higher income, and
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Table Four. Millennium Development Goals Goals
Targets
1. Eradicate extreme poverty & hunger
•
2. Achieve universal primary education 3. Promote gender equality & empower women
• • •
4. Reduce child mortality
•
5. Improve maternal health
•
6. Combat HIV/AIDS, malaria, & other diseases
• •
7. Ensure Environmental sustainability
• • •
8. Develop global partnership for development
• • • • • • •
Halve % people whose Y =
